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... II. THE EVOLVING ROLE OF SHAREHOLDERS IN CORPORATE GOVERNANCE A. The Activist Shareholder 1. The rise of the institutional investor 2. The SEC's 1992 proxy rule amendments 3. The emergence of shareholder advisory services 4. The rise of activist hedge funds 5. Financial innovation 6. Proposed changes in shareholder voting rules B. The Conflicted Shareholder 1. Conflicts arising from activists' transactions with the corporation 2. Conflicts arising from activists' interests in derivatives or securities of other corporations 3. Conflicts arising from activists' investments in other parts of the corporation's capital structure 4. Conflicts arising from activists' short investment horizons III. TOWARD A GENERAL THEORY OF SHAREHOLDER FIDUCIARY DUTIES A. Past and Proposed Responses to Activist Shareholder Overreaching B. Fiduciary Duties as a Response to Shareholder Overreaching 1. Expanding the notion of control 2. Expanding the notion of shareholder conflicts of interest 3. Incorporating traditional loyalty defenses IV. OBJECTIONS A. Increased Litigation B. Chilling Effects C. Majority Voting CONCLUSION
INTRODUCTION
In the typical American public corporation, power is dispersed among three key groups: shareholders, the board of directors, and the company's executive officers, including its Chief Executive Officer (CEO). Each group has rights and privileges. Each also has duties and responsibilities.
Contemporary corporate case law and scholarship, however, pay far more attention to corporate officers' and directors' duties than to shareholders'. Officers and directors are understood to owe fiduciary duties that are broad and deep, constraining their every material business decision. (1) Shareholders are thought to have far more limited obligations. In fact, outside the narrow contexts of closely held companies and self-dealing by majority shareholders, many commentators assume shareholders have no duties at all. (2) Minority stockholders in public companies are often viewed as free agents, at liberty to try to influence corporate policy as they see fit--including trying to influence corporate policy in ways that favor their own interests over those of the corporation and other shareholders.
The risk that minority shareholders in public firms might use their power in self-serving ways has understandably attracted little attention for two reasons. First, until recently, minority shareholders have played a largely passive role in public companies. This passivity has been driven by both economic and legal forces. From an economic perspective, the cost of trying to influence corporate policy has typically outweighed the likely impact of such effort on the value of any single shareholder's interest, leaving dispersed shareholders in public companies "rationally apathetic." (3) From a legal perspective, traditional corporate law rules have done little to overcome this hurdle. (4) The result has been that minority shareholders in public firms have been perceived as having far less power to set corporate policy than directors and officers have.
The second reason why the question of minority shareholders' duties has been largely overlooked is that, even when minority shareholders do try to take an active role in public companies, it has been generally believed that their primary goal is to improve the firm's overall economic performance--an interest that is closely aligned with both the interests of the firm and the interests of other shareholders. Shareholder activism, accordingly, has been assumed to be a beneficial influence. (5)
In this Article, we argue that both of the foregoing assumptions are becoming increasingly inaccurate. The economic and legal context in which American public corporations do business is changing swiftly in ways that create a pressing need to reexamine conventional notions of shareholder duties. As a result of recent developments in financial markets, business practices, and corporate law, minority shareholders are finding it economically rational to try to influence corporate decision-making. The long-standing assumption that public company shareholders lack the ability or incentive to engage in activism is no longer accurate. Meanwhile, even as shareholders are becoming more powerful, their interests are becoming more heterogeneous. Increasingly, the economic interests of one shareholder or shareholder group conflict with the economic interests of others. The result is that activist shareholders are using their growing influence not to improve overall firm performance, as has generally been assumed, but to profit at other shareholders' expense.
Consider the following three scenarios, each of which involves an activist shareholder seeking to advance its own interests to the exclusion or detriment of other shareholders' interests:
1. A large, publicly held corporation owns and runs a national chain of grocery stores. The chain becomes embroiled in bitter contract negotiations with its employees' union over proposed cuts in employee pay and benefits. The union publicly blames the dispute on the hard-line negotiating stance of the grocery chain's CEO. The employees' union runs a pension fund for its members. The union pension fund portfolio includes significant holdings of common stock in the grocery store chain. Using its status as a shareholder in the company, the pension fund mounts an aggressive proxy campaign to remove the company's CEO.
2. A hedge fund owns a large block of common stock in a troubled biotech company. To raise the stock's share price, the hedge fund urges the biotech company's management to put the company up for sale, but finding a buyer willing to pay a premium for the company's shares proves difficult. Finally, a large health sciences corporation expresses interest in acquiring the biotech firm. Industry analysts voice doubts about the acquisition, believing the price too high. At this point, the hedge fund buys 10% of the common stock of the possible acquirer. The hedge fund keeps formal title to the stock, along with its legal status as a shareholder in the acquirer and the right to vote 10% of the acquirer's common shares. However, the hedge fund enters into a derivatives contract with an investment bank to hedge away its economic interest in the acquiring corporation. If the acquirer's stock price declines, the investment bank, and not the hedge fund, will bear the loss. The hedge fund then approaches the acquirer's board and informs the board that if any of its members oppose buying the biotech company, the hedge fund will use its shareholder status to mount a proxy battle to remove that director from the board.
3. A small environmental services company raises $10 million in new capital from a private investment partnership. In return, the investment partnership gets 45% of the environmental services company's common stock and preferred stock with a $15 million liquidation preference (a right to receive liquidation proceeds that is senior to that of common stockholders). The liquidation preference can be triggered by a sale of all the company's assets approved by a majority of the board and a majority of the common shares. Just a few weeks later, the investment partnership announces it has found a third-party buyer willing to pay $15 million for all the environmental services company's assets. Because the asset sale would trigger the $15 million preferred stock liquidation preference, the company's common stock would become worthless. Thanks to its preferred stock interest, however, the investment partnership would make a quick 50% profit on its initial $10 million investment. The board of directors of the environmental services company, a majority of whom are investors in the investment partnership, quickly approves the asset sale. Because the investment partnership already owns 45% of the company's common shares, the sale will go forward if 5% or more of the firm's other common shares are voted in favor of the deal. The investment partnership approaches several other shareholders of the environmental services company who collectively own 6% of the company's common stock and offers them the opportunity to participate in unrelated business deals on highly favorable terms if they agree to vote their shares in favor of the asset sale. The asset acquisition is approved.
These scenarios are stylized variations of actual eases reported in judicial opinions or the business press. (6) They illustrate how minority shareholders in public companies can and do use their growing influence to push for corporate actions that serve their personal economic interests. It is unclear whether and to what extent the traditional rules of shareholder fiduciary duty reach such self-serving behavior. This lack of clarity has encouraged activist shareholders, especially hedge funds, to "push the envelope" in employing activist tactics to pressure corporate officers and boards into pursuing business policies that uniquely benefit the activist, while failing to hell--or even harming--the firm and its other shareholders.
We believe that fiduciary duty doctrine can and should be interpreted in a way that takes into account changes in the corporate landscape and reaches such opportunistic behavior. Indeed, we believe that the law of fiduciary duty is uniquely suited to address the growing problem that opportunistic shareholder activism poses for corporate governance. To this end, we propose concrete recommendations for furthering this doctrinal evolution.
Our approach has two advantages as a strategy for dealing with self-serving shareholder activists. First, it brings existing fiduciary duty doctrine into line with the changing reality of how and why shareholders assert power in the corporate governance arena. As a result, it offers a broad, flexible, and preemptive solution to the problem of shareholder overreaching. This seems likely to be a far more effective approach than the sorts of ad hoc, after-the-fact responses to particular forms of abusive shareholder behavior that regulators have adopted in the past and that prominent corporate law scholars continue to propose today. (7)
Second, we believe our reinterpretation of shareholder fiduciary duty can lend much-needed support to the controversial but increasingly influential normative claim that promoting "shareholder democracy" is a useful way to constrain managerial misbehavior. (8) In the wake of recent corporate scandals, firms and regulators have urged the adoption of a variety of changes in corporate law and practice designed to increase shareholders' power to pressure the directors of publicly held firms into adopting particular business policies, from requiring more independent directors, to de-staggering corporate hoards, to requiring shareholder votes on CEO pay. (9) Academics and investor interest groups are calling for even more "shareholder empowerment." (10) Whether or not the modern trend of shifting corporate power toward shareholders and away from boards and executives will ultimately serve shareholders' own interests depends critically on how individual shareholders and shareholder groups actually exercise their growing influence. By limiting their ability to use it in opportunistic and self-serving ways, we hope to encourage a version of shareholder democracy that promotes, rather than destroys, shareholder value.
Part I begins by briefly surveying contemporary corporate law rules of fiduciary duty, focusing especially on the duty of loyalty. The duty of loyalty is usually applied to corporate officers and directors, where it is interpreted as a presumption that any "interested" transaction--that is, any corporate transaction that provides a material personal economic benefit to the officer or director--is a potential basis for personal liability unless the officer or director can demonstrate to the court's satisfaction that the transaction, though tainted by self-interest, was nevertheless intrinsically fair to the corporation. In some cases, courts impose a similar fiduciary duty of loyalty on shareholders. However, courts impose those duties only on "controlling" shareholders, meaning shareholders who enjoy the ability to control the company's board of directors. Moreover, the vast majority of cases in which shareholder fiduciary duties have been applied involve either freeze-out transactions or closely held corporations. This pattern of very limited application of shareholder fiduciary duties is grounded in the assumptions that (1) minority shareholders in public firms are relatively powerless, and (2) minority shareholders share a strong common interest in improving corporate performance that reduces the risk of opportunistic behavior.
Part II discusses why both assumptions are becoming increasingly inaccurate. In recent decades, a number of important developments--including increased institutional investing, changes in federal proxy law, the creation of shareholder advisory services, the rise of activist hedge funds, and financial innovations that can magnify activists' voting power--have worked together to significantly shift the balance of power in public firms away from executives and boards and toward activist shareholders. The trend seems likely only to continue as would-be reformers push to increase shareholder power further. Meanwhile, as shareholders are becoming more powerful, they are also becoming more heterogeneous. Activist shareholders can have serious conflicts of interest with other shareholders arising from their other relationships with the firm, from their investments in derivatives or securities issued by other corporations, from their investments in other parts of the firm's capital structure, and from their short-term investment focus. Taken together, the two trends of shareholders becoming both more powerful and more divided point to an inevitable increase in the risk of shareholder opportunism.
Part III explores how American corporate law can address this increased risk through the relatively straightforward mechanism of applying corporate fiduciary duties to shareholders more broadly. In particular, activist shareholder overreaching can be deterred by interpreting loyalty duties to apply not only to controlling shareholders, who can dictate board decisions in all matters, but also to activist minorities who succeed in influencing management with respect to a single transaction or business decision. Moreover, shareholder fiduciary duties should be applied not only in the traditional contexts of freeze-outs and closely held corporations but also in any factual situation where a shareholder reaps a unique personal economic benefit to the detriment or exclusion of other shareholders. On first inspection, our proposal may seem a radical expansion of existing law. We show, however, that the scope of these admittedly expanded shareholder duties can be kept within reasonable bounds by allowing shareholders, like officers and directors, to rely on standard loyalty defenses, including the defense that their conflict of interest was not material or that the challenged transaction was intrinsically fair.
Part IV addresses several potential objections to our proposal, including the objections that it will foster excessive litigation, that it will chill beneficial shareholder activism, and that fiduciary duties for activist shareholders are unnecessary, as any attempt by activists to use their influence for personal gain will be checked by the principle of majority rule. Part IV demonstrates that none of these objections is persuasive.
We conclude by pointing out there is no reason to assume that activist shareholders are somehow impervious to the same temptations of greed and self-interest that are widely understood to face corporate officers and directors. Our proposed reinterpretation of shareholder fiduciary duties recognizes this reality.
I. FOUNDATIONS OF SHAREHOLDER FIDUCIARY DUTIES
A. Corporate Fiduciary Duties
One of the most basic concepts in corporate law is that of fiduciary duties. With modest variations, these duties fall into two broad categories: the duty of loyalty and the duty of care. (11) Both duties are usually discussed in the public company context as they apply to "managers" (that is, executive officers and corporate directors). We thus begin our discussion by surveying briefly how corporate fiduciary duties of loyalty and care are interpreted in this context.
In theory, corporate officers and directors owe the corporation and its shareholders a duty of care, meaning a duty not to act negligently. In practice, this duty has been modified (some might say extinguished) by the doctrine known as the "business judgment rule." The business judgment rule is usually described as a legal presumption that the directors and officers of the corporation have exercised due care by acting on an informed basis, in good faith, and in the honest belief that their actions are in the best interests of the corporation. (12) Unless a plaintiff can produce persuasive evidence rebutting one of these three elements, corporate directors and officers are effectively insulated from liability for breach of the duty of care.
It is very difficult for a plaintiff to establish, as a practical matter, that corporate managers who made even a token effort to perform their jobs were not "informed," especially in the face of case law suggesting that only a showing of gross negligence will make the case. (13) It is also difficult for a plaintiff to demonstrate convincingly that an executive or director who does not have a conflict of interest (which would raise loyalty issues) was nevertheless acting in "bad faith" or on the belief her decision would harm the corporation. For these and other reasons, (14) the duty of care offers notoriously weak protection against negligence by corporate officers and directors.
In contrast, the fiduciary duty of loyalty has teeth and provides the principal legal constraint against managerial misbehavior--and, we argue below in Part III.B, against shareholder misbehavior as well. As a result, it is the duty of loyalty that receives the lion's share of our attention. Unlike the duty of care, which applies even to well-intentioned decisions, the duty of loyalty focuses on motive. (15) Theorists have conceived of the nature of the duty in various ways, sometimes sounding in trust theory and other times in agency theory. (16) At its core, however, the duty of loyalty requires a corporate fiduciary (in this case, an officer or director) to act only in the best interests of the fiduciary's beneficiary (in this case, the firm and its shareholders). (17) In other words, the duty of loyalty asks managers to place the interests of the corporation and its shareholders above their own interests.
Given the human instinct for pursuing self-interest, (18) this is a tall order. How does loyalty doctrine attempt to fill it? Most obviously, corporate law discourages loyalty violations by adopting a modified version of the strict prophylactic prohibition, drawn from trust and agency law, known as the "exclusive benefit" rule. The exclusive benefit rule rests on the notion that if we want to ensure fiduciaries act only in their beneficiaries' interests, the first thing we must do is eliminate any possibility that fiduciaries can act in their own interests. This can be done by flatly forbidding fiduciaries from using their power over a beneficiary's assets in any way that might bring a fiduciary personal gain. Even though such "self-dealing" transactions might in some cases benefit both parties, they are strictly prohibited.
The justification for this traditional prohibition is twofold. First, absent such a strict rule, it is feared fiduciaries inevitably will be tempted to use their positions to benefit themselves at their beneficiaries' expense. Second, given the complex and ongoing nature of the fiduciary relationship, it is often not feasible to protect beneficiaries against this sort of opportunistic behavior through explicit contracts or careful monitoring. (19) Thus, the benefits of a strict prophylactic prohibition, according to the logic of the exclusive benefit rule, outweigh the costs.
Corporate law takes a much more relaxed view of the exclusive benefit principle than does the common law of trust and agency. In particular, it does not prohibit corporate fiduciaries from dealing with their firms or their shareholders. Rather, corporate law modifies the strict rule against self-dealing by allowing corporate officers and directors to use their corporate powers to pursue business transactions that benefit themselves as long as they are prepared to prove to a disinterested party--in particular, to a court--that the transaction, although self-interested, was nevertheless intrinsically "fair" to the corporation. (20) Thus, a corporate officer or director can be found liable for breach of the duty of loyalty only if (1) she uses her corporate office to promote a corporate transaction that provides her with material personal benefits and (2) the transaction is "unfair." It is not fiduciary self-dealing alone that is improper. Instead, it is unfair fiduciary self-dealing that is improper.
Procedurally, a plaintiff who seeks to hold a corporate officer or director liable for breach of the duty of loyalty has the initial burden of alleging that the contested transaction was tainted by self-interest. To do this, courts have generally held the plaintiff must show the officer or director stood to reap a material economic benefit from the transaction. (21) Once the plaintiff has shown the possibility of self-interest, the burden shifts to the defendant to demonstrate the intrinsic fairness of the transaction to the company. (22) In analyzing intrinsic fairness, courts consider both the terms of the transaction ("fair price") and the fairness of the bargaining process leading up to it ("fair dealing"). (23)
Here again, corporate law adds some important bells and whistles to traditional fiduciary duty doctrine. For example, the Delaware corporate code provides for two procedures that courts have deemed are so significant that, if officers and directors follow them properly, they shift the legal burden of demonstrating unfairness back to the plaintiff. In particular, a corporate officer or director can shift the burden of demonstrating unfairness by showing that the transaction in question, although admittedly self-interested, was nevertheless approved after full disclosure by either (1) a majority of the company's disinterested directors or (2) by a majority of the company's disinterested shareholders. If either showing is made, the burden of demonstrating unfairness reverts to the plaintiff. (24)
While corporate law's loyalty rules are more flexible than their traditional counterparts under the laws of trust and agency, (25) they share the same prophylactic character. Corporate officers and directors can engage in self-interested transactions, but only subject to the judicial test of fairness. And while defendants can shift the burden of showing unfairness onto the plaintiff by demonstrating that the conflicted transaction was disclosed to and approved by either the corporation's disinterested directors or its disinterested shareholders, fairness remains the judicial touchstone in corporate law loyalty cases.
B. Fiduciary Duties of Shareholders
As noted above, fiduciary duties are usually applied to officers and directors. In some cases, however, courts impose fiduciary duties of loyalty on certain types of shareholders as well. When they do, the analysis tends to follow the application of loyalty duties in officer and director cases. In particular, courts have held that majority shareholders, like corporate officers and directors, owe a fiduciary duty of loyalty to minority shareholders that precludes them from using their positions as controlling shareholders to extract material economic benefits from the firm at the minority's expense. (26) As articulated by the California Supreme Court in the case of Jones v. H.F. Ahmanson & Co., (27) "Majority shareholders may not use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority. Any use to which they put the corporation or their power to control the corporation must benefit all shareholders proportionately...." (28)
Consider, for example, an individual who owns 51% of a company's common stock and so can dictate who sits on the company's board of directors. Such a majority shareholder might be tempted to use his power over the board to push through a corporate transaction that provides a unique profit opportunity for him while harming minority shareholders. The classic example is a "freeze-out" merger in which the minority shareholders are forced to sell their shares, at an unfairly low price, to an entity that is wholly owned by the controlling shareholder. As in the case of interested transactions by corporate officers and directors, courts deem freeze-outs orchestrated by controlling shareholders to be interested transactions and potential violations of controlling shareholders' duties of loyalty. As in the case of corporate officers and directors, such interested transactions...
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